Giving ethical funds a green light

A combination of regulation change and increasing goodwill towards the sector has seen the number of ethical funds available to European investors rise dramatically in the last five years.

Ethical funds available to European investors have evolved a great deal over the past few years. Although one of the oldest funds, now called the F&C Stewardship Growth fund (S&P AA rated), was launched in 1984, the sector did not see any real increase in the number of funds until this millennium. According to Standard & Poor’s Pan-European funds database – available on www.funds-sp.com – over half of the ethical funds available today in continental Europe and Britain were launched after January 2000.

One of the reasons for the growth at this point was that the markets favoured the kind of stocks that many ethical funds invest in. However, the sector has also seen an improvement in sentiment towards it, as well as some regulation change. Ethical managers in the UK maintain that the ethical pension sector was given a boost in July 2000, when an amendment to the Pensions Act 1995 came into force asking pension trustees to disclose their stance on ethical issues. As a result, the managers say the comfort level with ethical investing is rising and it is becoming much more acceptable for funds to deal with environmental issues.

Ethical fund performance over the last three years has been strong. In fact, investors who bought into Britain’s Insight European Ethical Investment fund or France’s AGF Aequitas fund three years ago would have seen returns of over 40%. Over a third of the ethical funds returned double figures in the three years to June 20, 2005.

However, performance of ethical funds has been more a function of the markets. Their nature means most ethical funds have a strong bias toward mid and small-cap companies. Some of the world’s largest banks and pharmaceutical companies go against ethical funds’ policy, for example. Until this year mid and small-caps have seen a strong market, so a number of ethical funds have been able to build on this. Performances have suffered somewhat in 2005, owing to a technical rebound for large-caps, with the average fund returning only about 4% during this period.

There is no standard definition of what constitutes an ethical fund, with different funds applying different exclusion criteria. The Standard & Poor’s Ethical sector facilitates comparison of funds that promote themselves as ethical investments, and any analysis of individual funds should include a close look at the policies applied to ensure that they meet with the investors’ own principles. These different shades of ethical criteria may be referenced by the terminology used in the ecological and environmental sphere, where the terms light green and dark green are applied. Light green funds will try to find investment routes into areas that would normally be forbidden to dark green ethical funds. They may, for example, be allowed to invest in banks, but only those incorporated in specific ethical guidelines such as the Co-operative Bank. Investment in oil, to use another example, would be limited to exploration companies, rather than multinational integrated oil companies such as BP, Exxon and Shell.

The same can also be said of the ecological funds that are available to European investors. In Britain, Jupiter’s dark green Ecology fund looks for growing companies that fall under themes such as ecological transport, energy, waste and water companies. By contrast, its light green Environmental Opportunities fund picks the best companies within specific sectors. As a result, there are more large-cap companies in the fund and it has a bias on income.

The debate continues over whether light green or dark green funds will perform better, but any performance is more likely to come down to whether the markets are favouring larger or small and mid-caps, as, by their nature, light green funds are better able to invest in larger-caps.

Funds also differ vastly in size. The more mature British market contains most of the larger funds, including the largest – F&C Stewardship Growth, worth 628.9m. The smallest fund, at just 320,000, is France’s Groupama Euro Capital Durable Return. Whether the market will be able to sustain such small portfolios remains to be seen. Common consensus in the UK is that a portfolio must be 500,000 or more to be a viable operation for most investment houses.

Most British ethical funds are run by managers who work on unconstrained portfolios investing in the same region. The manager has general investment knowledge of the area in question and builds an ethical portfolio from a universe provided by the Ethical Investment Research Service (Eiris). Eiris collects substantial data on companies and their behaviour on ethical issues.

Most UK-based ethical funds use Eiris as their vetting agency. The fund group sets the ethical criteria and Eiris undertakes the screening process, leaving the fund manager free to construct a portfolio entirely on investment grounds. The screened universe of potential holdings is slightly smaller than for an unfettered portfolio, but this should not be a major constraint for a good fund manager. This use of an outside agency is a developing trend in Europe. Organisations providing research into ethics and corporate governance include Oekom Research in Germany, Switzerland’s Centre Info Suisse and the Swedish Caring Company.

Ethical managers are keen to stress that the things that matter are the same for ethical managers as they are for non-ethical managers – that is, asset allocation and fund management. The question of whether it is possible to invest ethically and make good returns has always been a key one, but many of the funds have proven that they are capable of making good returns. While ethical fund managers may be restricted in what they can invest in, they may be giving up only a relatively small degree of outperformance. There is nothing to stop an ethical fund manager who follows a disciplined and consistent approach from outperforming.